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Tuesday, 14 February 2012

Even on St Valentine's Day,
competitive instincts can
lead to strife ...

Doctor Nic is in danger of becoming very popular with the IPKat's readers right now. She receives more admiring emails even than Merpel and her exposition of economics for the IP fraternity has done a vast amount to raise this weblog's didactic-can-be-fun credentials. Anyway, this week's Katonomics post from Dr Nicola Searle deals with a topic which is a good less popular with our readers than she is: the devil incarnate, in legal terms -- the economics of competition. This is what she has to say about it:

"Closely related to economics of IP is economics of competition. Both areas span the fields of law & economics and industrial organisation. Likewise, both areas represent areas of significant regulation of the economy. In the UK, you can find economists analysing competition in academia, consulting firms and government bodies. For this post, we’ll take a look at the reasoning behind competition law.

To start, let me dispel a common myth. We do not have a capitalist economy. At least, we do not have a free-market capitalist economic system in the strict sense of the word. Instead, we have what is better described as a mixed economywhich is both market and state determined. Unlike the stereotypical Adam Smith, lassiez-faire dream of a free-market, we have substantial government involvement and public ownership.

So, most economies involve some form of government intervention. But why is it that we have government regulation of anti-competitive practices? The clue is the name – in general, we want more competition, not less.

Competition should minimise prices, maximise efficiency and encourage innovation. Competition is good for economies (more on this from the BIS). To illustrate the benefits of competitive markets, let’s look at less competitive markets (imperfect competition) such as a monopoly. A monopoly exists when there is a single seller of a good or service. This usually translates to greater profits for the single seller. For consumers, monopoly conditions typically result in higher prices, lower quantities and less choice. As a result, monopolies are generally considered unfavourable for economies.

Monopolies arise because of barriers to entry. Some barriers to entry create natural monopolies because of costs. A good example is the London tube system (can you imagine competing tubes?) In my Scottish seaside town, transportation costs explain why the single bicycle shop and hardware store enjoy geographical monopolies. Natural monopolies don’t keep economists awake at night but there is some debate as to whether they constitute a convenient excuse. I suspect we’ll see more on this as digital business models develop. Consider this - is Facebook a natural monopoly?

Other monopolies occur due to legal barriers to entry – for example, patents or government-granted franchises. However, firms may be able to create sufficient barriers to entry to manufacture a monopoly position for themselves. This is where governments tend to get involved.

The classic case of Standard Oil in the U.S. explains how firms can create near monopoly status by squashing competition. Standard Oil, through horizontal and vertical integration, was on its way to dominating the late 19th century American petroleum market. However, it did so through a variety of anti-competitive practices including undercutting prices until competitors went out of business or sold to Standard Oil, buying up oil barrel components so competitors couldn’t distribute, dodgy deals with transportation companies, industrial espionage, the use of threats or violence and other unsavoury acts.

Had Standard Oil been allowed to continue, it would have muscled its way into a monopoly. Long-term, this would have meant higher prices and lower quantities of petroleum (although, it might have staved off American oil addiction. Instead, their acts resulted in the breaking up of the Standard Oil trust and the Sherman Anti-trust Act (there is some evidence that the Standard Oil case was not this clear-cut -- but why let truth ruin a good story?)

As British economist Vickersnotes, European competition law is shifting to a more economic focus. Abuse of a dominant position, as in the case of Standard Oil, via activities such as predatory pricing, selective price cuts, margin squeezes and special discounts and rebates can restrict competition. The difficulty is that some of these practices have ambiguous results on competition. There is no hard and fast rule, thus each case has to be evaluated as to its economic impact.

Standard Oil also attracted attention as they acquired competitors. Mergers and acquisitions pose a challenge as they can result in reduced competition and monopolies. Economists use statistical modelling to predict the impact of a merger on competition and the market. This analysis is along the lines of the “but for” lost profits analysis in patent infringement cases. Like patent infringement cases, these economic predictions (not an oxymoron!) are debated.

Under market-based economies such as capitalism, incentive structures may put individual interests ahead of social interests at the expense of the economy as a whole. In the case of competition law, government intervention changes the incentive structure to discourage or punish the abuse of market power in favour of promoting overall economic welfare. However, IP law can actually create monopolies – so what is more important: incentives to innovate or competitive markets?